At first glance, Emily appeared to be the poster girl for financial responsibility. She worked hard for her money, and was absolutely committed to setting aside 10 percent of her annual gross income for retirement. Emily was fanatical about tracking her spending. Most importantly, she didn't flinch when forced to make the tough choices required to balance enjoyment today with security tomorrow. After all, Emily had heard over and over about the importance of saving early and often for her future. At age 35, she was rightfully proud of the $100,000 nest egg she had accumulated for her future.
So why isn't Emily a financial role model? The answer may surprise you - it's because Emily kept all of her retirement savings in cold, hard cash. See, it took enormous effort for Emily to save that money up. Consequently, she didn't want to do anything "risky" with it like "buy investments." Instead, she opted to keep the money under her mattress - literally. Upon hearing this, her pal Kiki practically choked on her lunch. Kiki went on to explain to Emily that by retirement age, the "value" of that $100,000 would be closer to $40,000 -- or less than half of what Emily had originally saved. Emily couldn't believe what she was hearing. She thought she was being safe with her money. How on earth could she lose by keeping her money in cash?
The answer is inflation. Inflation is simply a fancy way of saying that prices go up over time. In other words, $1,000 today won't buy nearly the same amount of stuff years down the road when you are ready to retire. How much less will it buy? Well, that depends on how fast prices rise. Over the past couple of decades inflation has averaged around 3 percent a year. This may not sound like much, but if every year prices go up around 3 percent, after 30 years $1,000 will only buy $400 worth of goods and services. It's even possible that going forward inflation could run higher than 3 percent -- thus making that $1,000 "worth" even less than $400 in the future.
So how do you combat inflation? You do it by investing responsibly. You have three basic choices for investing: stocks, bonds, and real estate. For now, we'll assume that Emily selects stocks for her long-term retirement savings. Over the long run, stocks have gone up an average of 10 percent a year. Why do you care? Well, if you think of inflation as a headwind coming at you at 3 miles per hour and investing in stocks as a tailwind pushing you forward at 10 miles an hour - you'll start to get our drift. Investing is so powerful for your long-term money for two reasons. First, it counteracts the negative effect of inflation. Second, it also provides you the chance to have your money grow so that $1,000 today buys even more than $1,000 of stuff in the future.
That said, it's important to note that the 10 percent figure for stocks is a historical average over an 80-year period. There's no guarantee that history will repeat itself. Also, on a year-by-year basis, stocks had a much bumpier ride than the long run historical average of 10 percent. As such, a good rule of thumb is that if you have a moderate risk tolerance, you should only invest money that you do not have to spend for at least five years. Money that you need to spend in the next one to five years is best left in "cash equivalents" like a savings account, money market account/fund, or a CD.
Emily was absolutely stunned to learn that by keeping her money stuffed under the proverbial mattress she was actually increasing - not decreasing - her risk with her long-term nest egg. To say she was grateful to Kiki for giving her a financial wakeup call is an understatement. Now both Emily and Kiki look forward to sipping an ice cold beer on the beach in retirement.
